To Cut or Not to Cut? That is the (Central Bank’s) Question In Search of the Neutral Interest Rate in Latin America

Abstract

This paper estimates neutral real interest rate (NRIR) ranges for 10 Latin American countries that either have full-fledged inflation targeting regimes in place or have recently adopted them, using an array of methodologies commonly used in the literature. We find that NRIRs have declined in the last decade, with more economically and financially developed economies exhibiting lower NRIR levels. Based on the estimated NRIRs, we assess that the current monetary stance (measured by the interest rate gap) is appropriately neutral in most of the considered economies, in line with closing output gaps. We also observe that the interest rate gap can be a good predictor of future inflation dynamics and economic growth. In addition, looking at the recent experiences in Brazil and Peru, we suggest that macro-prudential policies could affect the monetary stance even in the absence of direct interest rate changes, through affecting the NRIR.

Mexico

“…They also find a strong decline over time. Magud and Tsounta (2012) estimates of neutral interest rates in Latin America also establish a downward trend. The decline in global interest rates has been attributed to an increase in global saving rates related to demographic factors, increased demand for safe assets, low investment rates, and a decline in potential growth rates in a number of large economies.…”

The natural yield curve in Brazil

“…A closed-economy New-Keynesian model was used to assess neutral rates for Brazil in Palma & Portugal (2017), while Barbosa, Camêlo & João (2016) use a Taylor rule, with neutral rates assumed to evolve as the sum of foreign rates and risk premiums. Several different methodologies were employed by Muinhos & Nakane (2006), Magud & Tsounta (2012), and Perrelli & Roache (2014). This paper seeks to contribute to the literature on natural rates in Brazil through the use of yield curve data, as in Bomfim (2001), Christensen & Rudebusch (2017), and Ajevskis (2018).…”

Republic of Mozambique

“…With habit formation, the NRIR would be in the range 4.9 percent to 7.8 percent, with a mean value of 6.4 percent. We select the results with habit formation since the NRIR without habit formation are implausibly large as documented in Cochrane (2001), Campbell et al (1999), Magud and Tsounta (2012) and Fuentes and Gerdig (2007) for countries with similar characteristics to Mozambique. 22…”